Wednesday, December 17, 2008

Ultra-low US rates undermine repo market

By Michael Mackenzie in New York
Published: December 16 2008 23:33 Last updated: December 16 2008 23:33
Extremely low short-term interest rates in the US are sharply eroding the functioning of the government repurchase or repo market, a foundation stone for the financial system and trading Treasury debt.
While the Federal Reserve reduced its benchmark interest rate from 1 per cent to a new range of zero to 0.25 per cent on Tuesday, short-term market rates have been trading at close to zero per cent in recent weeks. Driven by a flight to safety by investors and expectations of rate cuts, such conditions are creating problems in the repo market, where investors borrow Treasuries in return for short-term cash loans.
EDITOR’S CHOICE
Awaiting the return of the repo market - Dec-16
This activity allows traders to sell Treasuries without owning them in the first place, while owners of government debt can fund their portfolios by lending Treasuries.
When rates tumble to low levels, it reduces the economic incentive to lend securities. The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close.
The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year.
“Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries,” said Michael Cloherty, strategist at Banc of America Securities. “We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.
“In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern.”
Problems in repo impair general trading across the Treasury market. A rise in so-called failed trades, where a borrowed security is not returned in a timely fashion, becomes a drain on the balance sheets of dealers. Low interest rates are also hampering the ability of dealers in financing positions by matching the different needs of clients, known as matching offsetting trades.
“The zero per cent interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market,” said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.